China must focus on manufacturing

China’s economy is at a crossroads. As 2013 begins, foreign and domestic observers alike are asking which path the country’s economic development should take in the next decade.

After the global economic crisis weakened external demand, which sustained China’s unprecedented economic growth for three decades, the authorities agreed that internal demand, especially domestic consumption, must become the country’s new growth engine. At the Chinese Communist Party’s congress in November, China’s leaders declared their intention to double per capita income by 2020, unleashing 64 trillion renminbi ($10.2 trillion) of purchasing power.

Indeed, with roughly 130 million middle-class consumers, China’s domestic market holds significant potential. The Boston Consulting Group estimates that, with an average annual gross domestic product growth rate of 7 per cent in China and 2 per cent in the US, Chinese domestic consumption will rise to half of that in the US by 2015, and 80 per cent in 2020 (assuming the renminbi appreciates at an average rate of 3 per cent against the US dollar over the next few years).

But China cannot rely on consumption as its only growth engine. History has shown that a one-dimensional development model cannot ensure sustainable competitiveness, just as no single market can sustain global demand. China must continue to develop its manufacturing sector.

It is the world’s top manufacturing country by output. But, while China accounts for 19.8 per cent of total global manufacturing, it receives less than 3 per cent of the world’s manufacturing R&D investment. So China’s innovative capacity remains relatively low, with its high-tech and knowledge-intensive industries unable to compete globally.

On average, China’s industrial enterprises are relatively small, and, although its industrial labour productivity (real manufacturing value added per employee) has improved over the last decade, it remains much lower than that of developed countries – just 4.4 per cent of US and Japanese productivity, and 5.6 per cent of Germany’s. The “pauperisation" phenomenon, in which companies must adjust their commercial strategies to cope with an impoverished consumer base, is increasingly affecting traditional industries, further undermining China’s capacity for sustainable development.

Moreover, the quality of Chinese-manufactured products continues to lag behind that of developed countries’ manufactured goods. Whereas one unit of intermediate input in developed countries typically generates one unit or more of added value, in China the ratio is only 0.56.

As China’s “demographic dividend" disappears, its low-end labour market is shrinking, driving up its once rock-bottom labour costs and diminishing its rate of return on capital. Over the next decade, as its workers demand higher salaries, basic benefits and better working conditions, the country may lose the comparative advantage that has driven its manufacturing boom.

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While manufacturing wages remain significantly lower in China than in the US, the rapidly narrowing gap is already fuelling American reshoring. Given that Chinese wages are rising at an annual rate of 15-20 per cent, productivity-adjusted wage rates in low-cost US states are expected to exceed those in some coastal regions of China by only 40 per cent in 2015. Add to that reduced energy costs in the US, owing to the country’s shale-gas revolution, as well as the global supply chain’s complexity, and China’s cost advantages will soon be negligible.

Meanwhile, other emerging economies – including Vietnam, India, Mexico and eastern European countries – are vying for China’s position as the world’s factory. These lower-cost alternatives are fast becoming developed-country investors’ preferred destinations.

Although the enormous potential of China’s consumer market can provide a new impetus for economic growth, the country’s economic transformation cannot succeed unless it upgrades its manufacturing sector.

China’s leaders must increase investment in science and technology, focusing on parlaying key technological breakthroughs into higher-value-added production. Only by combining growing Chinese consumption with enhanced Chinese manufacturing will the country be able to develop a new comparative advantage – the key to sustainable growth over the next decade.